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Sunday, December 28, 2008

Fiscal Policy Stimulus Smackdown

The usually reserved Tyler Cowen comes out swinging in this rebuttal to Paul Krugman and other fiscal policy stimulus proponents. He provides a number of good critiques, but this one I think is key:

Note that under standard theory neither monetary nor fiscal policy will set right the basic problems from negative real shocks and indeed the U.S. economy is undergoing a series of massive sectoral shifts. That includes a move out of construction, a move out of finance, a move out of debt-financed consumption, a move out of luxury goods, the collapse of GM, and a move out of industries which cannot compete with the internet (newspapers, Borders, etc.)

I've never seen a stimulus proponent deny this point about real shocks but I don't see them emphasizing it either. It should be the starting point for any analysis of fiscal policy but so far it is being swept under the proverbial rug.

Josh Hendrickson makes a similar point here in his discussion of what macroeconomic theory has to say about this crisis. My belief is that macroeconomic policy should aim to stabilize nominal spending while these negative real shocks are being worked out. This can be most easily accomplished through the existing policies of (1) shoring up the financial sector and (2) quantitative easing by the Fed. Note that it was the equivalent of these two policies in the 1930s the ended the Great Depression, not fiscal policy stimulus.

5 comments:

Keynesians such as Krugman and deLong seem constitutionally incapable of understanding this point about real sectoral shocks. They only see the basic Keynesian aggregate macro model. Krugman has been taken to task about this blind spot recently on the Austrian Economists website, and John Halasz eviscerated deLong about this in his lengthy and insightful comment on deLong's website (April 2 2008)

You argue that we should "shore up" the financial sector, but doesn't the financial sector need to shrink ? At the moment, policy is making the too-big-to-fail financial institutions even bigger(eg Chase-WaMu). There seems to be no real thought-out plan by the authorities of where this is going

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